The global monetary system is not immune to instability, and frequent crises since the 1971 end of the Bretton Woods system have allowed countries to let their currencies to float freely. Over the past two decades, financial crises have not only become more frequent, but have had an increasing impact on the global economy.
Against this backdrop, several trends have emerged that will create headwinds against longer-term growth. These trends include high debt-levels in much of the developed world, aging populations, and declining liquidity in both equity and credit markets. Those trends mean asset price and market volatility will persist for years to come — and that will require institutional fund managers to focus on strategically and tactically managing that volatility, and the associated risks.
Whether you are a pension investor responsible for securing employee benefits, an individual saving for retirement, an endowment or foundation facing liquidity needs, or any other type of investor, volatility in your investment presents risk. Not all risk is bad — in fact, it may be required to generate long-term growth. But unexpected or unplanned risk levels present enormous challenges.
There are many tools to help investors manage volatility depending upon their needs, objectives and individual circumstances. The decision to manage volatility can be made at two levels: the policy level (governance) or within investment strategies. Implementing volatility management can emphasize investment strategy level decisions, or it can emphasize policy level decisions, which are made at the governance level. Each must be recognized as very different techniques. At the policy level, there exists several strategic approaches and dynamic policies available to asset owners, generally at the overall portfolio. Strategy level is differentiated from the policy level in that it represents a series of techniques that are generally employed on specific parts of a portfolio in a more flexible manner.
Managing Volatility — Policy vs. Strategy
Institutional investors usually have a long-term strategic asset mix policy that they formally revisit every three years or so. However, with changes in accounting regulations, the freezing of DB plans to new entrants and increased market volatility, investment time horizons have been decreasing, and many institutional investors have modified their investment approach. Many DB plans are now using asset forecasts and a wider array of diversifying asset classes in an effort to manage volatility and exploit investment opportunities. Other strategic policy management approaches include risk parity, and outsourcing or insourcing.
Dynamic policy approaches are more fluid in nature and may include dynamic de-risking, opportunistic asset allocation, tail risk management, and hedging, and they generally have a short- to medium-term orientation. Unlike the more strategic long-term asset allocation approaches, these involve a level of nimbleness and flexibility that can help mitigate volatility and enhance potential return outcomes.
Once a policy-level approach has been established, the question then turns towards which implementation alternatives to use at the strategy level to manage volatility. These options, in order of increasing impact or influence on managing volatility, include: indexed and managed tracking error, yield or valuation sensitive fundamental management, liability-driven investing, and managed volatility and absolute return portfolio management.
It is a given that market uncertainty and market volatility will remain a constant. Given this reality, institutional investors are increasingly adopting a formal approach to managing volatility. It is important for investors to create a framework for managing their discussions around risk. It is equally important for fiduciaries to distinguish between policy-based and strategy-level considerations. As such, it remains imperative that institutional investors educate themselves on the array of tools to manage volatility, regardless of the specific measures they decide to adopt.
Ravi Venkataraman, CFA, is senior managing director; global head of consultant relations & defined contribution, MFS Investment Management